Economics focus

Steering by a faulty compass

Are central banks watching the wrong measure of inflation?

LAST week, for the first time, America's Federal Reserve published its forecast of inflation over the next two years. Many observers took this as a sign that the Fed had moved closer to setting an inflation target, as many other central banks have done. The minutes of the Fed's February meeting, published this week, confirmed that its policymakers have discussed the idea. Advocates of targeting argue that it would increase the transparency of America's monetary policy and maintain its credibility after Alan Greenspan retires as Fed chairman in 11 months' time. But at which measure of inflation should the Fed take aim?

It is widely agreed that central banks' prime goal should be price stability. Judged by existing consumer-price indices, central banks have indeed tamed inflation. But there are important things that such indices ignore—homes and shares, for instance. And the prices of these have been rising fast in many countries. Central banks should worry about those as well.

When inflation targets were first introduced (in New Zealand in 1989), the exact measure of inflation did not matter much. The main objective then was to reduce high rates of inflation by anchoring expectations. Today, however, consumer-price indices are arguably too narrow. Charles Goodhart, a former member of the Bank of England's Monetary Policy Committee, has long argued that central banks should instead track a broader price index which includes the prices of assets, such as houses and equities. America's core rate of consumer-price inflation (excluding the volatile prices of energy and food) rose by 2.3% in the year to January. But house prices rose by much more, 13%, in the year to the third quarter of 2004 (the latest official figures available). These are excluded from America's consumer-price index (CPI); instead the cost of home ownership is represented by rents. But this can be misleading: over the past year, rents have risen by just over 2%, a lot less than house prices.

Ian Morris, an economist at HSBC, has devised a broader index, which includes house prices, giving them a weight of 30%, the same now attributed to the notional “rent” paid by homeowners in the core CPI. In the year to the third quarter, inflation as measured by this broad index was 4.9%, more than twice the rise in the core CPI. Assuming that house-price inflation has continued at the same pace, The Economist calculates that broad inflation is now 5.5%, the highest since 1982 (see chart). Moreover, during the past three decades the gap between the two measures of inflation has never been so wide for so long.

If inflation in America is really higher than the official index suggests, then interest rates should also be higher. Similar measures would show inflation well above the standard figures in many other countries too. The main exceptions are Japan and Germany, where house prices have been falling.

A long economic pedigree

The idea that central banks should track asset prices is hardly new. In 1911 Irving Fisher, an American economist, argued in a book, “The Purchasing Power of Money”, that policymakers should stabilise a broad price index which included shares, bonds and property as well as goods and services. Central banks already take account of asset prices by estimating their effect on wealth and hence on demand and future inflation, but the idea behind a broad price index goes much further, acknowledging that asset-price inflation can be harmful in its own right.

The most obvious way is through a giddying rise and subsequent crash of markets for shares or property. Big swings in asset prices can also lead to a misallocation of resources and so slower economic growth, just as high rates of general price inflation distort economies by blurring relative price signals. For instance, soaring property prices can encourage households to borrow too much and save too little, and can pull excessive resources into property at the expense of other forms of investment.

More fundamentally, if inflation is defined as “changes in the value of money”, then the consumer-price index is flawed because it only measures the prices of current consumption of goods and services. A classic paper written in 1973 by two American economists, Armen Alchian and Benjamin Klein, argued that people care about changes in the prices not only of the goods and services they consume today, but also of what they use tomorrow. Because assets are claims on future goods and services, their prices are proxies for the prices of future consumption. If I buy a house—ie, a claim on future housing services—and its price is higher than a year ago, then surely that should be included in inflation since it reduces the purchasing power of my money. Many consumer durables, such as cars, which also provide services over several years, are already included in the CPI.

If the prices of goods and services and those of assets move in step, then excluding the latter does not matter. But if the two types of inflation diverge, as now, a narrow price index could send central bankers astray. Granted, asset prices are hard to measure: a rise in house prices may partly reflect an increase in the average quality of homes; and economists disagree over what weight house prices should have in a broad index. Yet buying a home is an enormous expense, so it is absurd to use such a rough approximation as rent, as does America's CPI, or to exclude the costs of owner-occupier housing altogether, as does the European Union's harmonised index of consumer prices.

Given the elusiveness of a perfect price index, central banks should keep using conventional, narrow inflation targets, but be prepared to undershoot them temporarily if house or share prices soar. This means taking a longer view than hitherto: an inflation target looking only two years ahead is too short-term. And although the calculation would be tricky, central banks might usefully publish broad price indices, including asset prices, beside existing measures. They would then find it easier to explain why they must sometimes raise interest rates when conventional inflation is low.